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Does Your Manager Invest Alongside You?

And why that shouldn't be the only question you ask.

It's not always easy to distinguish good mutual funds from the bad ones. After all, with more than 8,000 actively managed mutual funds, index funds, and exchange-traded funds vying for your attention, things can get confusing. I've always advised investors to look for funds with long-tenured managers, low fees, a consistent investment process, and solid performance in good and bad market environments. But beyond that, are there more clues as to whether a fund manager really believes in his or her talents?

Eating your own cookingOne measure that some fund watchers like to highlight is how much money managers invest in the fund they manage. After all, one might ask, if the manager isn't willing to put his money where his mouth is, why should anyone else? Investing a significant, or even a fairly reasonable, amount of his money in the fund he runs shows a dedication to the process and to the results.

Unfortunately, most mutual fund managers come up somewhat short on this count. According to data from Morningstar, only about 40% of fund managers actually invest in their own funds. That's not a huge vote of confidence from the folks who are supposed to have some of the clearest insights into where the best opportunities in the market are! Of the 6,557 funds studied by Morningstar, 4,347 had at least one manager who hadn't invested a dime in the fund. Some analysts point out that this could indicate a weak company culture that is not shareholder-focused. Indeed, Morningstar's research has shown that the more money a portfolio manager invests in a fund, the better it does. So does this mean you should pass on a fund if the manager isn't investing along with you?

Take it in contextWhile I surely like to see managers invest in the funds they run, I don't think this measure alone should necessarily make or break your decision about owning any particular fund. There may be some perfectly acceptable reasons why managers don't invest heavily in their own funds, especially if the funds are narrowly focused on a certain sector or country and it doesn't make sense for the manager to take on such undiversified risk. Ditto if the manager is relatively young but runs a bond fund; it wouldn't make sense for him or her to devote large chunks of money to a fixed income strategy.

And if you consider the fact that most financial professionals advise workers not to load up on their company's stock within their 401(k) or other retirement accounts so as to diversify risk, the same logic would apply to a portfolio manager. After all, if your salary and employment status depend on your job performance, I can see a reason to ensure that large chunks of your retirement savings aren't similarly contingent on that same job performance.

That being said however, I do think that fund managers need to step up and put a little more of their money at risk alongside their shareholders. There's really no reason why only 40% of funds have managers who are willing to do so. But while I think fund ownership can be an important tool in picking funds, it shouldn't be a deal breaker. If all else were equal between two funds and one fund's manager invests heavily in her fund and the other invests nothing, I'd say go with the former. But we all know things are rarely equal, and that means other factors can, and should, weigh more heavily in the fund selection process.

For example, according to insider fund ownership measures, the Vanguard Group comes up short. According to Morningstar, of Vanguard's 114 funds, only 33 have investments from their fund managers. While that's not a point in their favor, I don't think it takes away from the fact that Vanguard offers perhaps one of the best fund lineups in the business. One primary reason is that Vanguard places such an emphasis on keeping costs low, thus helping to boost performance. Personally, I'd rather have a well-run, low-cost fund with a solid track record behind it, even if the manager didn't invest, than an expensive, undiversified, volatile fund where the manager invests lots of his own money.

Buying with the bestHowever, for investors who like the idea of buying funds with managers that commit their own capital alongside of yours, there are a number of big-name funds that measure up on that front.

The management team over at Dodge & Cox isn't afraid to invest in their own funds. At Dodge & Cox Stock (DODGX), for example, seven of the fund's nine managers have more than $1 million invested in the fund. Here, the team is big on low-P/E, high-yielding health-care names such as Pfizer(NYSE: PFE), Sanofi(NYSE: SNY), and Novartis(NYSE: NVS). Stock picking has been first-rate over the years, leading the fund to a 9% annualized return over the past decade and a half, ahead of 97% of all large-cap value funds.

Likewise, at American Funds Growth Fund of America (AGTHX), six of the fund's 12 portfolio managers have more than $1 million of their own money invested in the fund. It ranks in the top 5% of all large-cap growth funds in the past 15 years and is now one of the largest mutual funds around. However, the fund should still have plenty of room to grow assets, especially given the portfolio's current focus on low-priced tech names, a sector I think should do well in the next 12 months. Here, reasonably priced fast-growers likeApple(Nasdaq: AAPL) and Google(Nasdaq: GOOG) land along with more restrained and lower-P/E choices like Corning(NYSE: GLW). If you can buy the fund without paying the front-end load, Growth Fund of America is a solid choice for any growth investor.

Ultimately, investors should consider fund manager ownership when selecting their funds and take it as a very positive sign when managers buy in along with fund holders. However, there are other factors that are likely even more important when picking funds, so make sure you use fund ownership as just one tool in your selection process and not as the primary criterion.

Amanda Kishis the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Motley Fool owns shares of Apple and Google.Motley Fool newsletter serviceshave recommended buying shares of Google, Pfizer, Novartis, and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.